When it comes to paying off loans typically there are 2 typical ways to work through the problem, which we can look at some alternate strategies, there is even a 3rd unorthodox way to paying off faster potentially. Today we will look at strategy #1 and in future posts we will discuss the remaining strategies.
1. Pay more over the life of the loan.
Strategy #1
To accomplish strategy #1 you either have spare money and you pay off the loan faster, or you find a way to take extra work and pay off the loan faster.
This strategy works well, and of course the more spare money you have to throw at a problem the faster you can solve it, however it should be interesting to note, you can look at this strategy as a way of lowering your interest rate. Technically you aren't lowering your interest rate however, what you can do is say, I have a target of 1.75% interest rate on my loan, and pay enough extra so at the end of the loan you've paid the equivalent effective interest.
Effective Interest
Why would you want to do this? Well suppose you have a couple loans. Each loan paid till their full term has a rate. If you pay off that loan earlier than when considering the life of the loan you've reduced your overall interest. What this does is let you compare other loans, and realize that dumping *all* your money into one loan, and skipping over others may not be optimal. Lets use an example.
Suppose you have a loan for 100K that is at 4.5% interest rate, and a car loan for 18K at 2.75% interest rate. Our target is 1.75% interest rate on the home. and 1.75% interest rate on the car.
First we look and see that a 100K loan at 1.75% would run in terms of total interest.
28K is our goal interest paid for the life of the loan. Now when we look at this we have to basically ignore the payment and only consider the total interest. Looking at the loan's 4.5% interest rate we see we have a base payment of $506 and we will be paying 82K for interest, so a pretty big difference. To manually calculate this, we apply some amount of money on a monthly basis against the loan using a calculator and then look at what the resulting final interest is. This may take a little time, but once you figure it out, then you know your numbers.
In this scenario we pay off an extra $425 a month on our $509 a month loan and we will net an effective interest rate of 1.75% for the life of the loan. What's interesting is that if you look at the numbers, it's a non linear return in terms of money in vs interest saved. As shown below we can see we see a lot of benefit in our lower additional monthly payments, but it's a logarithmic strategy.
How I look at it is this way. Once I have reached my target interest rate on the home, we now restrategize on the car and begin to put more money on that.
For the car our loan would cost us $1286 in interest and to reduce to $812 is our goal. So we follow the same process and discover that if we pay about $165 we hit our target interest rate.
Of course this isn't a great analysis unless we look at how much interest we saved for each of the loans and compare the overall.
Loan 1 we paid an extra $425 and saved $54K in interest. Loan 2 we paid an extra 160 and resulted in a savings of $400 in interest. Suppose we just paid the extra $160 on the home. Well this is only slightly an unfair comparison, if I apply the $160 to the loan, it'll go for the entire life (longer than 5 years which my calculations are based on).
So even though it's a lot longer term of payments on the 160 it comes out to us paying 22K in interest so we save another nearly 6K.
What if we took that 160 a month and assumed it was really 160 * 5 * 12 (total amount paid extra on the loan over 5 years) it comes out to 9600, now we divide that by 12 and 30 to make that payment go across the life of the 30 year loan, so we paid the same extra, but just split it, that comes out to 26 bucks extra a month this comes out to paying closer to 27K which is very close to the 28K we are already saving, so you see that we save a tiny bit more averaged across on the higher interest rate loan, but it's very close to the same. I think that to make this comparison more equal there might need to be some normalization, and then we can really compare apples to oranges, I'll perhaps figure out how to do that in a future post.
Which is the right approach to take? It's a little inconclusive at this point, but hopefully we can build a case in the future.
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